DIVIDEND POLICY

 What is Dividend?
 What is dividend policy?
 Theories of Dividend Policy
Relevance Theory
◼ Walter’s Model
◼ Gordon’s Model

Irrelevance Theory
◼ M-M’s Approach
◼ Traditional Approach
What is Dividend?

“A dividend is a distribution to shareholders out of

profit or reserve available for this purpose”.

- Institute of Chartered Accountants of India

Forms/Types of Dividend

 On the basis of Types of Share

Equity Dividend
Preference Dividend
 On the basis of Mode of Payment
Cash Dividend
Stock Dividend
Bond Dividend
Property Dividend
Composite Dividend
 Contd.

 On the basis of Time of Payment

Interim Dividend
Regular Dividend
Special Dividend
What is Dividend Policy?

 “ Dividend policy determines the division of

earnings between payments to shareholders
and retained earnings”.

- Weston and Bringham

 Contd.

Dividend Policies involve the decisions, whether-

To retain earnings for capital investment and

other purposes; or
To distribute earnings in the form of dividend
among shareholders; or
To retain some earning and to distribute
remaining earnings to shareholders.
Factors Affecting Dividend Policy

 Legal Restrictions
 Magnitude and trend of earnings
 Desire and type of Shareholders
 Nature of Industry
 Age of the company
 Future Financial Requirements
 Taxation Policy
 Stage of Business cycleRegularity
 Requirements of Institutional Investors
Dimensions of Dividend Policy

 Pay-out Ratio
Funds requirement
Liquidity
Access to external sources of financing
Shareholder preference
Difference in the cost of External Equity and
Retained Earnings
Control
Taxes
 Contd.

 Stability
Stable dividend payout Ratio
Stable Dividends or Steadily changing
Dividends
Types of Dividend Policy

 Regular Dividend Policy

 Stable Dividend Policy
Constant dividend per share
Constant pay out ratio
Stable rupee dividend + extra dividend
 Irregular Dividend Policy
Theories of Dividend
 Dividend Theories

Relevance Theories
(i.e. which consider dividend
decision to be relevant as it
affects the value of the firm)
Irrelevance Theories
(i.e. which consider dividend
decision to be irrelevant as it
does not affects the value of the
firm)

Walter’s Gordon’s
Model Model

Modigliani and Traditional

Miller’s Model Approach
Walter’s Model
 Prof. James E Walter argued that in the long-
run the share prices reflect only the present
value of expected dividends. Retentions
influence stock price only through their effect
on future dividends. Walter has formulated this
and used the dividend to optimize the wealth
of the equity shareholders.
 Assumptions of Walter’s Model:
Internal Financing
constant Return in Cost of Capital
100% payout or Retention
Constant EPS and DPS
Infinite time
Walter’s Model
D + r (E-D)
P = k
k
Where,
P = Current Market Price of equity share
E = Earning per share
D = Dividend per share
(E-D)= Retained earning per share
r = Rate of Return on firm’s investment or Internal Rate of
Return
k = Cost of Equity Capital
Illustration:
 Growth Firm (r > k):
r = 20% k = 15% E = Rs. 4
If D = Rs. 4
P = 4+(0) 0.20 /0 .15 = Rs. 26.67
0.15
If D = Rs. 2
P = 2+(2) 0.20 / 0.15 = Rs. 31.11
0.15
Illustration:
 Normal Firm (r = k):
r = 15% k = 15% E = Rs. 4
If D = Rs. 4
P = 4+(0) 0.15 / 0.15 = Rs. 26.67
0.15
If D = Rs. 2
P = 2+(2) 0.15 / 0.15 = Rs. 26.67
0.15
Illustration:

 Declining Firm (r < k):

r = 10% k = 15% E = Rs. 4
If D = Rs. 4
P = 4+(0) 0.10 / 0.15 = Rs. 26.67
0.15
If D = Rs. 2
P = 2+(2) 0.10 / 0.15 = Rs. 22.22
0.15
Effect of Dividend Policy on Value of Share

Case If Dividend Payout If Dividend Payout

ratio Increases Ratio decreases

1. In case of Growing Market Value of Share Market Value of a share

firm i.e. where r > k decreases increases

2. In case of Declining Market Value of Share Market Value of share

firm i.e. where r < k increases decreases

3. In case of normal firm No change in value of No change in value of

i.e. where r = k Share Share
Criticisms of Walter’s Model

 No External Financing
 Firm’s internal rate of return does not always
remain constant. In fact, r decreases as more
and more investment in made.
 Firm’s cost of capital does not always remain
constant. In fact, k changes directly with the
firm’s risk.
 Gordon’s Model

❑ According to Prof. Gordon, Dividend Policy

almost always affects the value of the firm. He
Showed how dividend policy can be used to
maximize the wealth of the shareholders.
❑ The main proposition of the model is that the
value of a share reflects the value of the future
dividends accruing to that share. Hence, the
dividend payment and its growth are relevant in
valuation of shares.
❑ The model holds that the share’s market price is
equal to the sum of share’s discounted future
dividend payment.
 Assumptions:
All equity firm
No external Financing
Constant Returns
Constant Cost of Capital
Perpetual Earnings
No taxes
Constant Retention
Cost of Capital is greater than growth rate
(k>br=g)
Formula of Gordon’s Model

E (1 – b)
P =
K - br

 Where,
P = Price
E = Earning per Share
b = Retention Ratio
k = Cost of Capital
br = g = Growth Rate
Illustration:

 Growth Firm (r > k):

r = 20% k = 15% E = Rs. 4
If b = 0.25
P0 = (0.75) 4 = Rs. 30
0.15- (0.25)(0.20)
If b = 0.50
P0 = (0.50) 4 = Rs. 40
0.15- (0.5)(0.20)
Illustration:

 Normal Firm (r = k):

r = 15% k = 15% E = Rs. 4
If b = 0.25
P0 = (0.75) 4 = Rs. 26.67
0.15- (0.25)(0.15)
If b = 0.50
P0 = (0.50) 4 = Rs. 26.67
0.15- (0.5)(0.15)
Illustration:

 Declining Firm (r < k):

r = 10% k = 15% E = Rs. 4
If b = 0.25
P0 = (0.75) 4 = Rs. 24
0.15- (0.25)(0.10)
If b = 0.50
P0 = (0.50) 4 = Rs. 20
0.15- (0.5)(0.10)
Criticisms of Gordon’s Model

 As the assumptions of Walter’s Model and

Gordon’s Model are same so the Gordon’s
model suffers from the same limitations as the
Walter’s Model.
Modigliani & Miller’s Irrelevance Model

Value of Firm (i.e. Wealth of Shareholders)

Depends on

Firm’s Earnings

Depends on

Firm’s Investment Policy and not on dividend policy

 Modigliani and Miller’s Approach

 Assumption
Capital Markets are Perfect and investors
Rational
No taxes
Floating Costs are nil
Investment opportunities and future profits of firms
are known with certainty (This assumption was
dropped later)
Investment and Dividend Decisions are
independent
Argument M-M’s Approach
 If a company retains earnings instead of giving it
out as dividends, the shareholder enjoy capital
appreciation equal to the amount of earnings
retained.
 If it distributes earnings by the way of dividends
instead of retaining it, shareholder enjoys
dividends equal in value to the amount by which
his capital would have appreciated had the
company chosen to retain its earning.
 Hence,
the division of earnings between dividends and
retained earnings is IRRELEVANT from the point
of view of shareholders.
Formula of M-M’s Approach

1 ( D1+P1 )
Po =
(1 + Ke)
Where,

Po = Market price per share at time 0,

D1 = Dividend per share at time 1,
P1 = Market price of share at time 1
Ke = Cost of Equity Capital
Criticism of M-M Model

 No perfect Capital Market

 Existence of Transaction Cost
 Existence of Floatation Cost
 Lack of Relevant Information
 Differential rates of Taxes
 No fixed investment Policy
 Investor’s desire to obtain current
income
Traditional Approach
 This theory regards dividend decision merely
as a part of financing decision because
The earnings available may be retained in the
business for re-investment
Or if the funds are not required in the business
they may be distributed as dividends.
 Thus the decision to pay the dividends or
retain the earnings may be taken as a residual
decision.
 This theory assumes that the investors do not
differentiate between dividends and
retentions by the firm
 Thus, a firm should retain the earnings if it
has profitable investment opportunities
otherwise it should pay than as dividends.
 Discussed so far:
 Dividend is the part of profit paid to
shareholders.
 Firm decide, depending on the profit, the
percentage of paying dividend.
 Walter and Gordon says that a Dividend Decision
affects the valuation of the firm.
 While the Traditional Approach and MM’s
Approach says that Value of the Firm is irrelevant
to Dividend we pay.